SOX Section 404 Backlash

Dec 28th 2005

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Sarbanes-Oxley (SOX) has been law since July 2002 and the collapses and financial carnage created by Enron, Tyco International, WorldCom, Adelphia Communications, HealthSouth, and Cendant, may have lost their prominence in people’s minds. Bloomberg reports executives are becoming more vocal that SOX has become an overzealous exercise to contain and detect corporate corruption. Section 404 is the current battlefield.

“I would like to see it opened and revised. Sarbanes-Oxley has become extraordinarily expensive,” said David Chavern, vice president of capital markets at the U.S. Chamber of Commerce in Washington, D.C. told Bloomberg.

The number of U.S. financial restatements climbed 28 percent over 2003 to 2004, prompted by SOX, according to the Huron Consulting Group. Office Depot CEO Steve Odland, told Bloomberg, “You have more independent eyes scrutinizing the decision making and the financial statements of the companies.” Odland is also the chairman of the Business Roundtable’s corporate governance task force.

Several changes have come about as a result of SOX. The New York Stock Exchange requires that boards have a majority of independent directors now. The year 2001 saw 61 percent of boards with independent directors, compared with 89 percent in 2005, according to the National Association of Corporate Directors. Bloomberg reports that only three, of the eight directors of the bankrupt commodities exchange Refco, were independent.

Also prosecutors, armed with broader penalty guidelines in cases of financial fraud, are winning longer prison sentences, according to former Justice Department (DOJ) criminal division chief, Christopher Wray. “The severity of the sentences serves as an ominous reminder of the consequences of misconduct. Executives engage in cost-benefit analysis every day. It’s not surprising that they would be more responsive to deterrence,” Wray told Bloomberg. He now defends white-collar clients at the firm King & Spalding LLP, in Atlanta.

Former CEO Bernie Ebbers was given a 25–year sentence for his part in WorldCom’s record $11 billion corporate fraud case, the largest in U.S. history. He is currently 63 and may die in prison effectively making his sentence a life sentence. The two former executives of Adelphia Communications received sentences greater than 15 years, according to CBC. Cendant’s Kirk Shelton got 10 years for his part in the accounting scandal that cost investors’ and his former company $3 billion. Tyco’s Dennis Kozlowski and Mark Swartz received 8 1/3 to 25 years for their pillaging.

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Bloomberg reports that coming in January, former Enron executives will finally be coming to trial. Former Enron CEOs Ken Lay and Jeffrey Skilling and Chief Accounting Officer Richard Causey, face long prison sentences if convicted of fraud and conspiracy charges at their trails, scheduled to begin January 17, 2006.

Former federal prosecutor Robert Mintz said to the Associated Press, “This era of corporate fraud was essentially defined by Enron and it’s really surprising that it’s taken the government this long to bring this case to trial given its level of complexity.”

“I often say Enron was really sophisticated and analogous to working with a scalpel, while at WorldCom it was more of a meat-ax approach,” former U.S. Attorney General Richard Thornburgh told the Associated Press. Former federal prosecutor Sam Buell said, “WorldCom could occur in any era, its more traditional book cooking. Its hard to think of another one of these cases that really is like Enron in the sense that it raises fundamental questions of accounting and financial reporting.” He summarized, “The deepest, most complex, most system-related case would be the last one to be resolved in all of this.” Buell was a member of DOJs Enron Task Force and now teaches at the University of Texas School of Law.

At the same time as former corporate executives are receiving longer sentences, DOJ has deferred corporate prosecutions in lieu of heavy fines, strengthened internal controls, and removal of those responsible for the wrongdoing. Bristol-Myers Squibb committed securities fraud and now has two years to improve their accounting procedures, allow a retired judge to monitor the agreement, and appoint an independent director acceptable to prosecutors, and a nonexecutive chairman.

“The agreements really do get into social engineering and corporate minutiae that prosecutors are not expert in. The government needs to trust those decisions to corporate directors,” former U.S. Attorney Mary Jo White who represented Bristol-Myers Squibb, told Bloomberg. She also believes prosecutors are interfering with the internal operations of companies.

With compliance to SOX Section 404 necessary for all public companies due in 2007, small companies are feeling financial burdens of $1 million annually. Groups representing hundreds of technology, biomedical, and venture capital companies, including the Biotechnology Industry Organization, are leading the main front against Section 404.

The groups writing to the SEC said, “The disproportionate cost burdens, arising out of a ‘one-size-fits-all’ approach to Section 404 continue to hamper the companies’ ability to invest in research and development,” according to Bloomberg. In April, the SEC will receive an SEC advisory committee recommendation to exempt small companies, with market capitalization of less than $750 million, from the requirement for auditors to verify their internal controls.

Opposition to this recommendation is coming from organizations including the Council of Institutional Investors (CII), saying that SOX has benefited small and large companies alike. Bloomberg reported CII Executive Director Ann Yerger wrote to the SEC, “Such a shift is a slippery slope that the council fears would ultimately seriously harm the investing public.”